Godding (pictured) says that the flood of money into the markets was largely due to the removal of the “tail risk” of a systemic collapse sparked by the eurozone crisis.
However, valuations have now returned to a level that outstrip fundamentals, which means that a correction is likely before the next leg up. “It is a given that the equity markets have been driven by excess financial liquidity and that valuations have been able to normalise now that the central banks have removed the “tail risk” of a liquidity driven collapse, particularly in Europe,” he said.
“However, the degree of appreciation since last summer has eliminated much of the excess risk premium available to investors, implying that we are in the later stage of this particular bull phase rather than the beginning.”
Data from FE Analytics shows that the FTSE 100 has made 34.94 per cent since June 2012. However, many commentators have pointed to the lack of support for the gains in the economic fundamentals, and Godding says that this lack of support makes a correction likely.
Performance of index since June 2012
Source: FE Analytics
“Our assessment is that investors have essentially “paid up front” for the benefits of liquidity, and we would not be surprised if the disconnect between the market and the economy in the short term leads to correction in equities,” he said.
“We are struggling to identify the catalyst at present, but it may simply be that buyers get exhausted in the short term, just as sellers get exhausted in bear markets.”
“In this context, a 5 per cent correction would be a healthy consolidation and pause for the real economy to catch up and act as a foundation for the next leg.”
However, Godding says that investors should remain in equities in the medium term, and a 5 per cent correction could be a good entry point.
“Our models at the start of this year suggested annualised returns from equities of close to 10 per cent for the next three years and those targets remain valid today,” he said.
“The fact that we are up 15 per cent in the UK in five months implies that we are ahead of the return curve, but there is no rule that dictates the returns will be spread evenly over the three year horizon.”
“The risk reward for investors with a three year time frame remains good relative to cash, bonds, corporate debt and high yield and a 5 per cent correction would make that return potential even better.”
Godding says that if investors want to avoid taking the 5 per cent hit he expects, they could increase their exposure to stocks through the emerging markets.
“If investors are keen to get involved, we suggest that the unloved emerging markets offer a good entry point at current levels,” he said.
“Central Europe is highly geared to a recovery in Europe, which is being rapidly discounted by European investors.”
Data from FE Analytics shows that Eastern European funds have struggled over a five year period, with specialist funds from Baring, BlackRock, Charlemagne, Invesco and Pictet all down over that period, suggesting that their markets have yet to be re-rated in the recovery of the last year.
Pictet Eastern Europe, a €268m Luxembourg-domiciled vehicle, and Invesco Perpetual Emerging European, which amounts to just £36m in funds under management, are the highest-rated options in the space, with four FE crowns each.
Data from FE Analytics shows that the Invesco fund, which is managed by Liesbeth Rubenstein, has made 20.66 per cent over three years as its benchmark, the MSCI EM Eastern Europe index, has made 14.38 per cent.
Performance of fund versus index over 3yrs
Source: FE Analytics
Godding says that there could still be potential in the broader emerging markets too.
“Falling commodity prices may be bad for the top line in some countries such as Brazil and Russia but they relieve inflationary pressures for the emerging consumer in India, China and many other resource importers.”
The UK market fell over 1.7 per cent in early trading this morning, in response to poor economic data from China and yesterday’s speech from Federal Reserve chairman Ben Bernanke.
Bernanke said the Federal Reserve might withdraw from quantitative easing within the next few meetings if economic data continued to be healthy.
It is unclear at this point whether the fall will be significant or will quickly retrace its path.
Bestinvest’s Jason Hollands also says that any sustained correction could be an attractive entry point.
“A short term correction at some point was always likely. For long-term investors is not unhealthy and not a cause for panic. Indeed any sustained correction would provide an attractive entry point into equity markets,” he said.
Hollands points out that the Japanese market has suffered most in today’s sell-off.
“As a market which has been attracting considerable attention from international investors recently on the back of the radical reforms dubbed Abenomics, and which has posted exceptional returns over the last six months, it is perhaps unsurprising that having risen the most, Japanese equities would take the biggest hit on the latest jitters.”
“We still think it is one of the most interesting stories in town, particularly once reforms of the corporate sector get underway.”
However, the analyst says he is more concerned about the poor Chinese data.
“China remains a worry, something we have flagged for some time. This week our CIO Gareth Lewis has set out in his latest Investment Outlook our view that the world is going to have to get used to lower and more sustainable Chinese growth rates as well as our concerns about the country’s shadow banking system.”
“An adjustment phase for China will have connotations for both global emerging markets generally and commodities as well.”
Hargreaves Lansdown’s Adrian Lowcock says there is no sign this current dip is based on fundamentals or will last.
“Such a sharp fall appears to be an overreaction to what was the merest hint of a change in attitude from the US Federal Reserve,” he said.
“Markets never rise smoothly and falls or corrections are par for course when it comes to investing.”
“It is important to put this is context, prior to today the FTSE 100 had risen consecutively for 16 days, and even after the drop it has only slipped to levels seen last week. The FTSE 100 is up 15.74 per cent total return year-to-date.”
“It is difficult to predict where markets will go in any one year and even more difficult to predict what will happen day to day.”
“Investors need to remain focused on their long term objectives and remember over the longer term equities have tended to rise and out-perform other asset classes.”